A Primer on the Secondary Mortgage Mortgage Market Note Market July 21, 2008 MORTGAGE MARKET NOTE 08-3 I. Introduction A secondary mortgage market consists of financial institutions and individuals that buy and sell residential mortgages and mortgage-backed securities (MBS), which are financial assets whose cash flows are derived from groups of mortgages. The secondary market in the U.S. is highly developed. Today, three-quarters of the dollar volume of single-family loans are funded through the sale of MBS, up from three-fifths in 2001, and most sales of whole loans occur as part of the creation of pools of mortgages that collateralize MBS. This primer on the U.S. secondary mortgage market discusses the three national submarkets for MBS, focusing primarily on single-family mortgages. The primer reviews the types of securities traded, the roles of various types of market participants, the forward or “To-Be-Announced” (TBA) market, and recent market trends. II. Three Submarkets for MBS The most important parts of the U.S. secondary mortgage market are the three national submarkets for MBS: 1. The market for MBS issued or guaranteed by Fannie Mae and Freddie Mac, two government-sponsored enterprises chartered by the Congress to support the secondary mortgage market. Those Enterprises guarantee MBS backed by nonjumbo single-family mortgages—loans with balances less than a prescribed limit (“the conforming loan limit”), which in 2008 is $417,000 for one-unit properties in areas of the country not designated as high-cost areas—as well as multifamily mortgages. Nearly all the loans backing MBS guaranteed by Fannie Mae and Freddie Mac are conventional mortgages—loans that carry no government insurance or guarantee. 1 2. The market for MBS guaranteed by the Government National Mortgage Association (Ginnie Mae), a Federal government agency that guarantees MBS issued by private firms and backed by pools of single- and multifamily mortgages insured by the Federal Housing Administration (FHA) or guaranteed by the Department of Veterans Affairs (VA) or the Rural Housing Service, each of which is also a Federal agency. 3. The market for private-label MBS (PLS). Those securities carry no guarantee by Ginnie Mae, Fannie Mae, or Freddie Mac and are collateralized by pools of conventional single-family mortgages with balances that are too large for the Enterprises to buy (jumbo loans) or are not underwritten to the Enterprises’ standards, including loans to borrowers that have credit problems of varying degrees of severity or provide little documentation, home equity mortgages, and loans that finance investor properties. Multifamily mortgages may be included in pools that contain other types of commercial mortgages and are financed with private-label commercial MBS (CMBS). At the end of 2007, outstanding MBS backed by single-family mortgages totaled $6.6 trillion. Securities guaranteed by Fannie Mae and Freddie Mac accounted for $4.1 trillion, MBS guaranteed by Ginnie Mae accounted for $0.4 trillion, and PLS accounted for $2.1 trillion of that total (Figure 1). Between 1990 and 2007, single-family MBS outstanding grew at an average annual rate of 11.3 percent. The composition of MBS outstanding changed significantly over that period, however. The private-label share increased from 5.1 percent to 31.9 percent, with most of that growth occurring in this decade, and the Ginnie Mae share fell from 37.5 percent to 6.8 percent. The Enterprise share declined from 42.6 percent to 38.7 percent over the period. 2 Figure 1 Mortgage-Backed Securities Outstanding by, Issuer $7,000 $6,000 $5,000 $4,000 Billions $3,000 $2,000 $1,000 $0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Fannie Mae and Freddie Mac Private-Label Ginnie Mae Source: Fannie Mae, Freddie Mac, Inside Mortgage Finance Publications Issuance of PLS increased dramatically, both in dollars and as a share of total MBS issuance, in the five years between 2001 and 2006. Whereas in 2001 19.7 percent of MBS issued were PLS, by 2006 that share had climbed to 56.0 percent (Figure 2). Ginnie Mae MBS declined from 12.7 percent of total issuance to 4.1 percent. The share of MBS issues guaranteed by Fannie Mae and Freddie Mac declined from 67.5 percent to 39.9 percent, over the period. Figure 2 Distribution of MBS Issuance, by Issuer $3,000 $2,500 $2,000 s $1,500 Billion $1,000 $500 $0 2001 2002 2003 2004 2005 2006 2007 2008Q1* Fannie Mae Freddie Mac Private-Label Ginnie Mae * Estimated annual volume based on quarterly activity. Source: Fannie Mae, Freddie Mac, Inside Mortgage Finance Publications 3 The second half of 2007 and the first quarter of 2008 saw a reversal of those trends. Issuance of PLS fell dramatically in those quarters as high default rates early in the lives of recently-originated subprime mortgages led to a liquidity crisis in the secondary market for PLS and turmoil in financial markets. Issuance of PLS dropped from $1.1 trillion in 2006 to $707 billion in 2007. Drops in issuance of PLS backed by subprime and Alt-A mortgages accounted for most of the decline (Figure 3). Issuance of PLS backed by jumbo loans also declined. If continued at the rate in the first quarter of 2008, PLS issuance will total $86 billion for the year.1 Figure 3 Private-Label MBS Issuance by Sector $500 $450 $400 $350 s $300 $250 Billion $200 $150 $100 $50 $0 2000 2001 2002 2003 2004 2005 2006 2007 2008Q1† Jumbo Alt A Subprime Other* * All other MBS issuance includes MBS backed by second-lien mortgages and MBS backed by resecuritized loans from other MBS. † Estimated annual volume based on quarterly activity. Source: Inside Mortgage Finance Publications The drop in issuance of PLS backed by jumbo mortgages was accompanied by a substantial increase in the spread between the interest rates on fixed- rate jumbo and nonjumbo loans. In an effort to address that issue, the Congress included provisions in the Economic Stimulus Act of 2008 that temporarily raised the conforming loan limit from $417,000 nationwide (for one-unit properties) to as much as $729,750 in high-cost areas. The temporarily higher limits apply to mortgages made between July 2007 and December 2008. The Act also established temporarily higher limits for FHA- 1 Subprime lending involves the provision of credit to borrowers who have past credit problems of varying severity and low credit scores. Alternative-A (Alt-A) mortgages are made to borrowers who generally have limited income or asset verification or are self- employed. 4 insured mortgages originated in high-cost areas. Those changes will likely increase the Enterprises’ and Ginnie Mae’s shares of total MBS issuance in 2008. Proposed legislation to reform federal regulation of Fannie Mae and Freddie Mac passed by the House of Representatives in 2007 and currently being considered in the Senate would establish permanently higher conforming limits in high-cost areas. Enactment of that legislation would permanently boost the market shares of the Enterprises and Ginnie Mae, even if the PLS market recovered. III. Types of MBS MBS are issued by trusts that hold title to groups (or pools) of mortgages for the benefit of investors. MBS differ in terms of the number of classes of securities issued, the type of collateral backing the securities, the means of credit enhancement, and how risks are allocated among investors. Single-Class MBS. A single-class MBS represents an undivided beneficial interest in the mortgages underlying the trust. The trust pays each investor in the MBS a pro rata share of the scheduled principal and interest from mortgagors on the loans backing the security. Interest is paid at a specific interest rate. Investors also receive any unscheduled payments of principal. Single-class MBS are often termed “pass-through certificates” because the monthly payments are “passed through” on a pro rata basis to the investors. Single-class MBS are almost always guaranteed as to timely payment of principal and interest by Ginnie Mae, Fannie Mae, or Freddie Mac and, when backed by 30- and 15-year mortgages, are often first sold through the TBA market. Unlike Ginnie Mae’s guarantee, which carries the full faith and credit of the U.S. government, those of Fannie Mae and Freddie Mac are guarantees of private corporations. Indeed, MBS guaranteed by the Enterprises carry an explicit disclaimer of any federal guarantee. Nonetheless, investors perceive an implicit federal guarantee of Enterprise- guaranteed MBS. Private credit rating agencies grant triple-A ratings to MBS guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac. The mortgages underlying a single-class MBS, while not identical, generally have broadly similar characteristics. For instance, a pool of thirty-year fixed-rate mortgages backing a Fannie Mae MBS might contain mortgages that were originated in the last year and have a weighted average life of three months and that carry interest rates of between 6 and 6.5 percent and have a weighted-average coupon rate of 6.25 percent. 5 The coupon rate on a single-class MBS is generally slightly lower than the weighted-average coupon rate on the underlying mortgages. That difference covers servicing fees (paid to the servicer) and guarantee fees (g-fees) paid to Fannie Mae, Freddie Mac, or Ginnie Mae as compensation for the credit guarantee of the securities. Each of those agencies offers several pass- through products (e.g., Ginnie Mae I, Ginnie Mae II, Freddie Mac Gold, Fannie Mae Megas) that vary in terms of the underlying loans, the servicing fees, and the lag between payment on the mortgages and payment to the MBS holders.